Articles

DESIGNING MONETARY AND FISCAL POLICY RULES IN A NEW KEYNESIAN MODEL WITH RULE-OF-THUMB CONSUMERS

Raffaele Rossi^a1 c1

^a1 University of Milano-Bicocca

Abstract

This paper studies the determinacy properties of monetary and fiscal policy rules in a small-scale New Keynesian model. We modify the standard model in two ways. First, we allow positive public debt in the steady state as in Leeper [Journal of Monetary Economics 27, 129–147 (1991)]. Second, we add rule-of-thumb consumers as in Bilbiie [Journal of Economic Theory 140, 162–196 (2008)]. Leeper studied a model in which Ricardian equivalence holds, and he showed that monetary and fiscal policy can be studied independently. In Bilbiie's analysis, rule-of-thumb consumers break the Ricardian equivalence and generate important consequences for the design of monetary policy. In his model, steady-state public debt was equal to zero. We study a model with both rule-of-thumb consumers and positive steady-state public debt. We find that the mix of fiscal and monetary policies that guarantees equilibrium determinacy is sensitive to the exact values of the parameters of the model.

Keywords:

• Rule-of-thumb consumers;
• Ricardian equivalence;
• Public debt;
• Monetary–fiscal policy interactions

Correspondence:

^c1 Address correspondence for Raffaele Rossi, Department of Economics, University of Milano-Bicocca, Piazza dell'Ateneo Nuovo 1, 20126 Milan, Italy; e-mail: raffaele.rossi1@unimib.it.

Footnotes

For helpful feedback and discussions, I am particularly grateful to two anonymous referees, Roger Farmer (the Associate Editor), Florin Bilbiie, Michela Cella, Andrea Colciago, Campbell Leith, Malcolm McColl, Ioana Moldovan, Giorgio Motta, Charles Nolan, Patrizio Tirelli, and Luca Stanca, and all the participants at the 4th European Macroeconomic Workshop and at the seminars of the economics departments of Glasgow and Milano-Bicocca Universities.